2011 International Monetary Fund

July 2011 IMF Country Report No. 11/197 January 29, 2001 January 29, 2001 January 29, 2001

XXXX XX, 2011 January 29, 2001

Zambia: Ex Post Assessment of Longer-Term Program EngagementUpdate

This Ex Post Assessment of Longer-Term Program Engagement on Zambia was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed on May 31, 2011. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Zambia or the Executive Board of the IMF. The policy of publication of staff reports and other documents by the IMF allows for the deletion of market-sensitive information. Copies of this report are available to the public from International Monetary Fund Publication Services 700 19th Street, N.W. Washington, D.C. 20431 Telephone: (202) 623-7430 Telefax: (202) 623-7201 E-mail: publications@imf.org Internet: http://www.imf.org

International Monetary Fund Washington, D.C.

INTERNATIONAL MONETARY FUND ZAMBIA Ex Post Assessment of Longer-Term Program EngagementUpdate Prepared by an Inter-Departmental Staff Team1 Approved by the African Department and the Strategy, Policy, and Review Department June 6, 2011 Key Messages Following the guidance in Ex Post of Members with a Longer-Term EngagementRevised Guidance Note, this EPA Update focuses on: (a) whether staff drew on lessons of Zambias 2004 EPA in designing more recent programs; (b) Zambias macro economic performance and program results; and (c) priority areas for any future Fund-supported program. Strong macroeconomic performance since 2004 reflects both positive terms of trade and improvedif at times unevenmacroeconomic, financial, and structural policy implementation. Drawing on the lessons of the 2004 EPA contributed to the broad success of the more recent Fund-supported programs. Zambia should consolidate this performance with a well-articulated medium-term economic program leading to greater economic resilience and to strong poverty reduction and growth. The Fund could support such a medium-term program, with the choice of instrument depending on economic circumstances. A stable, sustainable macroeconomic position must be the foundation of an effective medium-term program. This EPA Update elaborates four additional policy themes important to building economic resilience and promoting growth: Laying the groundwork to sustain low inflation Increasing effective investment in public infrastructure Mobilizing domestic revenues Developing the financial sector

This EPA Update was discussed with the Zambian authorities, whose views are presented in Appendix I.

The team comprised Sarwat Jahan (SPR), Nils Maehle (AFR), and Brad McDonald (SPR, head).

2 Contents Page

I. Introduction ............................................................................................................................3 II. Drawing on Priorities of the 2004 EPA Contributed to Macro Performance .......................3 III. Priority Areas for Any Future Program Engagement ..........................................................7 A. Laying the Groundwork to Sustain Low Inflation ....................................................7 B. Infrastructure Development Presents Twin Challenges ............................................8 C. Mobilizing Domestic Revenues ..............................................................................10 D. Financial Sector Development ................................................................................11 IV. Future Fund Engagement ...................................................................................................13 Figure 1. Zambia: Cross Country Comparison, 200010 .....................................................................6 Appendix Tables 1. Performance on Quantitative Performance Criteria and Benchmarks Under the 200407 PRGF................................................................................................................................16 2. Performance on Quantitative Performance Criteria and Indicative Targets Under the 200811 ECF ...................................................................................................................16 3. Zambia: Performance on Structural Performance Criteria and Structural Benchmarks Under the 200407 ECF ..................................................................................................17 4. Zambia: Performance on Structural Performance Criteria and Structural ...........................19 References ................................................................................................................................14 Annex 1. Response of the Zambian Authorities ..................................................................................20

3 I. INTRODUCTION 1. Since the 2004 EPA (IMF Country Report No. 04/214), Zambia has had two Extended Credit Facility (ECF)2 arrangements under the IMFs Poverty Reduction and Growth Trust (PRGT). The first (ECF-1) was in place from June 2004 to September 2007 and the second (ECF-2), approved in June 2008, is scheduled to expire in June 2011. Although problems in program implementation occasionally emerged, including with misreporting,3 program reviews have been concluded on schedule or with only minor delays. During this period Zambia also received debt relief of about US$3 billion under the HIPC Initiative, reaching the completion point in 2005, and additional relief of US$3 billion under the MDRI in 2006. This report covers: 4 Zambias macroeconomic performance under Fund-supported programs, Whether and how staff drew on lessons identified in the first EPA, and Priority areas for any future program. The first two topics are closely related and are covered in Section II. Section III presents four themes for any future program thatpursued together with policies to ensure continued macroeconomic stabilitywould support greater economic resilience and more rapid growth. 2. II. DRAWING ON PRIORITIES OF THE 2004 EPA CONTRIBUTED TO MACRO PERFORMANCE 3. The 2004 EPA highlighted that, despite improved economic growth, poverty in Priority Areas from the 2004 EPA Zambia remained formidable. The EPA Fiscal consolidation to reduce real interest rates and identified several priority areas important to promote private domestic investment macroeconomic stability and enhanced medium Limiting the wage bill to facilitate poverty-reducing term growth and poverty reduction. The strategy of spending and public infrastructure Upgrading public expenditure management the medium-term programs launched in 2004 and Attracting more donor support with improved 2008 (ECF-1 and ECF-2) closely reflected the program implementation EPA lessons and drew on the priority areas, with Stronger budget processes to improve governance the support of IMF technical assistance (TA) ( 9). A consistent policy for mining and tax exemptions Completing the privatization program Several aspects brought clear success and help to Financial sector development
2 3

Formerly the Poverty Reduction and Growth Facility (PRGF).

Two misreporting episodes came to light during ECF-2. Nonconcessional debt at end-2009 was slightly larger than reported originally; this was treated under the Funds de minimis procedures (See IMF Country Report No. 10/383). Government net domestic financing at end-2009 was larger than reported originally, leading to a breach of that ceiling; this matter is now being addressed. The need for improved debt management is cited in Section III.
4

Guidance on the coverage of EPA updates is presented in paragraph 8 of Ex Post Assessments of Members with a Longer-Term Program EngagementRevised Guidance Note.

4 explain the strong economic performance during 2004-10. However, less progress in areas such as expenditure management and infrastructure development, the tax regime, and financial sector development have meant that Zambias growth is not yet entrenched, benefits are narrowly shared, and the economy remains relatively concentrated and vulnerable. This leaves the authorities an important medium-term agenda, key elements of which are presented in Section III. 4. ECF-1 (2004-7) called for fiscal consolidation to contain the domestic debt and interest payments that jeopardized macro stability and social spending. As tax revenue performance was then considered strong, the focus was on limiting the wage bill and avoiding unplanned expenditures. Although issues in budget execution persisted, the fiscal discipline and reduced resort to domestic financing fostered price stability, particularly as the authorities became more adept at sterilizing inflows associated with high copper prices. Program conditionality was largely adhered to (Appendix Tables 1 and 3), and economic performance during this period was strong: growth and international reserves improved more quickly than anticipated; inflation declined; and government spendingincluding on wages and salarieswas contained (Figure 1). Government capital spending fell sharply, however, largely because of a sharp drop in project aid. 5. The strategy of ECF-2 (2008-11) emphasized more strongly medium-term growth, with diversification to make this growth more broad-based and resilient. Macroeconomic policies were to be geared toward creating space to increase spending on infrastructure and human resources by strengthening revenues. Reflecting the 2004 EPA priorities, this would be done in part by a new fiscal regime for mining and a more consistent approach toward tax exemptions. Improved budget and expenditure management and public procurement reform would enhance spending efficiency and encourage donor support. 6. Macroeconomic outcomes during ECF-2 were particularly 12 Government Capital Expenditure (Percent of GDP) strong. Growth increased further and reserves, supported by very 10 strong copper prices, increased markedly. The wage bill and total Externally 8 financed expenditures were lower than initially projected; however, grants and Domesticaly 6 financed revenues were also well below projections (in part due to the import 4 compression following the global financial crisis). Thus, capital expendituresrather than recoveringdeclined further. Inflation was 2 0 higher than initially targeted (in part due to surges in food and fuel 2003 2004 2005 2006 2007 2008 2009 2010 Source: Zambian authorities. prices), and higher than in other African LICs (reflecting higher-thanBroad Money Forecasts and Outturns for Zambia, 2005-10 targeted money growth and a high inflation legacy), (Percent change) 2005 2006 2007 2008 2009 2010 and scope remains to improve monetary 18.2 14.3 13.6 12.4 15.6 19.3 Forecast management. Financial sector reforms enhanced Outturn 3.3 44.0 25.3 23.2 7.7 29.9 stability, including by addressing issues regarding Source: IMF staff estimates. One-year-ahead projections based on September/October WEO. insolvent non-bank financial institutions and by strengthening the Bank of Zambias regulatory and supervisory functions.
1 1

5 7. The global financial crisis significantly affected Zambia through a sharp, but relatively brief, fall in copper prices. Exchange rate appreciation partially offset the surge in food and fuel prices in 2008. The program responded to these shocks by augmenting access and adjusting targets: the 2007 inflation target was increased to take account of the first-round effects of higher food and fuel prices, while monetary and fiscal policies were loosened during 2009 to stimulate activity.
Zambia: 2004-07 ECF Program Performance: Targets 1 and Outcomes (Percent of GDP unless otherwise indicated) 2004 Int. target 3.5 20.0 1.0 18.7 -8.6 5.4 27.3 9.2 7.9 2.2 2005 Act. Int. target 5.4 4.5 17.5 15.0 1.1 1.5 18.2 18.6 -8.4 -9.8 5.5 6.6 26.6 28.4 8.7 10.0 7.7 7.9 -0.1 1.2 Act. 5.3 15.9 1.5 17.6 -3.4 2.0 21.0 2.4 7.9 1.4 2006 Int. target 5.0 10.0 1.7 18.6 -9.3 6.9 27.9 10.5 7.9 0.9 Act. 6.2 8.2 2.2 17.1 -5.4 4.3 22.5 3.8 7.4 2.0 2007 Int. target 5.0 5.0 1.9 18.6 -9.3 7.0 28.0 11.5 7.7 0.5 Act. 6.2 8.9 2.5 18.4 -4.8 4.6 23.2 4.4 7.8 -0.1

Real GDP (percent change) CPI, eop (percent change) Reserves (months of imports) Revenues Overall balance (excluding grants) Grants (excl. debt relief) Total expenditure Capital expenditure Wages and salaries Domestic financing (net)

Source: Zambian authorities and staff estimates. 1/ Program targets for 2004-07 are based on the request for three-year arrangement under the ECF (EBS/04/70). Zambia: 2008-11 ECF Program Performance: Targets 1 and Outcomes (Percent of GDP unless otherwise indicated) 2008 Int. target 6.2 7.0 3.2 21.2 -6.5 5.3 27.6 5.2 8.4 -0.1 Act. 5.7 16.6 2.1 18.9 -5.0 4.1 23.9 4.0 8.1 1.2 2009 Int. target 6.3 5.0 4.7 22.1 -4.5 5.4 26.7 5.8 8.6 -1.5 Act. 6.4 9.9 5.1 16.0 -5.5 2.9 21.4 3.7 8.2 2.6 2010 Int. target 6.5 5.0 5.5 21.5 -5.0 5.3 26.4 6.8 8.7 -0.9 Act. 7.6 7.9 4.0 17.8 -4.9 1.8 22.7 4.5 8.1 3.0

Real GDP (percent change) CPI, eop (percent change) Reserves (months of imports) Revenues Overall balance (excluding grants) Grants (excl. debt relief) Total expenditure Capital expenditure Wages and salaries Domestic financing (net)

Source: Zambian authorities and staff estimates. 1/ Program targets for 2008-10 are based on the request for three-year arrangement under the ECF (EBS/08/53).

8. Despite strong growth and the overall success of Zambias 2004-11 Fundsupported programs, extreme poverty remains high. Information is incomplete, but while urban poverty declined markedly it appears that rural poverty declined only modestly. This may reflect the concentration of growth in highly capital-intensive or urban-based sectors like mining, construction and services, while per capita agricultural growtha key factor for the rural populationlagged. Agriculture growth picked up in 2008-10, but policies that kept maize prices artificially high disadvantaged the urban poor and the one third of smallholders that are net buyers of maize.
Zambia: Selected Poverty and Income Indicators 1998 58 71 36 69 166 2006 2009 51 67 20 94 155 16 97 141 15 6 33 90 96 75 845 791 992 1027 884 994 1221 1079 2010
Zambia: Per Capita GDP Volume Growth (Percentage change) 2000-03 2004-07 2008-10 GDP at market prices 2.2 3.8 4.6 GDP excluding mining sector 1.9 3.6 4.0 Agriculture, forestry, and fishing -1.4 Mining and quarrying 6.4 Manufacturing 3.2 Electricity, gas, and water 0.3 Construction 12.1 Services 1.7 Memo Sub-Saharan Africa African LICs Non-fragile African LICs Comparators 3.0 0.8 1.6 2.9 -0.3 6.2 2.1 1.9 16.8 3.0 4.6 3.6 4.4 4.0 3.5 10.5 0.8 2.4 6.7 4.2 2.2 2.8 3.3 3.2

Incidence of extreme poverty Rural Urban Primary school enrollment (%)1 Mortality rate, under-5 (per 1,000)1 Unemployment (% of labor force)2 Rural Urban Informal sector employment (% of total) Rural Urban Real income per capita (US$, 2010 prices) Gross domestic product Gross national income

Source: Zambia Central Statistical Office.

1

Non-f ragile Af rican LICs are: Benin, Burkina Faso, Ethiopia, Ghana, Kenya, Madagascar, Malaw i, Mali, Mozambique,Niger, Rw anda,

Sources: Zambia CSO, World Bank WDI, and IMF staff calculations.
1 2

2000, 2005, and 2009 respectively. 2005 and 2008 respectively.

Senegal, Tanzania, Uganda, and Zambia.

2

Comparator countries are: Ghana, Kenya, Mauritius, Mozambique,

Nigeria, Senegal, Tanzania,and Uganda.

6 Figure 1. Zambia: Cross Country Comparison, 200010 /1

8 Real GDP Growth (In percent) 30

Inflation (In percent ) Zambia African LICs Comparators

6 20 4 10

Zambia African LICs Comparators

0 2000 4 2 0 -2 Overall Fiscal Balance, Including Grants (In percent of GDP) 2002 2004 2006 2008 2010

0 2000 8 4 0 -4 -8 2002 2004 2006 2008 2010

External Current Account, Including Grants (In percent of GDP)

-4 -6 -8 2000 260 240 220 200 180 160 140 120 100 80 2000 2002 2004 2006 2008 2010 Zambia African LICs Comparators Terms of Trade (Index, 2000=100) 2002 2004 2006 Zambia African LICs Comparators 2008 2010

-12 -16 -20 2000 6 5 4 3 2 2002 2004

Zambia African LICs Comparators 2006 2008 2010

Gross Reserves, (In months of imports of goods and services)

Zambia 1 0 2000 2002 2004 2006 2008 2010 African LICs Comparators

Sources: IMF, African Department database, April, 2011; and World Economic Outlook (WEO) database April, 2011. 1/ Comparators countries are: Ghana, Kenya, Mauritius, Mozambique, Nigeria, Senegal, Tanzania, and Uganda.

7 III. PRIORITY AREAS FOR ANY FUTURE PROGRAM ENGAGEMENT 9. Zambias key challenges resemble those of other LICs (IMF staff, 2010). Economic growth, although improved, has not reached the levels needed to attain the Millennium Development Goals (MDGs), nor adequately benefitted the areas and sectors where the poor are most numerous. And despite weathering quite well the recent global financial crisis, Zambia can do more to reduce vulnerabilities to future shocks. Reflecting both unfinished areas from the 2004 EPA (Section II) and some new issues, the authorities should give particular attention to four key challenges: (i) sustain the recently achieved low to moderate levels of inflation, (ii) reverse declines in capital spending and strengthen public infrastructure, (iii) mobilize domestic revenues, an area where Zambia has begun to lag comparator countries, and (iv) build on progress since the 2004 EPA to further develop the financial sector. The agenda for public financial management (where improvements are needed to support infrastructure development) and the tax regime can draw from TA already delivered by the IMF and other providers.5 A. Laying the Groundwork to Sustain Low Inflation 10. Having achieved single-digit inflation, Zambia will need to consider how best to manage monetary policy in a low to moderate inflation environment. Under the authorities current regime, based on monetary targeting and exchange rate flexibility, monetary and fiscal restraint successfully reduced inflation. With lower inflation, however, exogenous shocks become relatively more important and the short-term trade-offs between price, output, and exchange rate stability become more difficult. Transitioning toward a monetary framework that best suits this environment is on the agenda throughout the region (IMF, 2008). 11. The Zambian authorities plan to reform their monetary policy framework. They are considering a gradual shift from strict monetary targets to a framework that would use interest rates as the main instrument to anchor inflationary expectations, perhaps leading eventually to an explicit inflation targeting (IT) regime. While inflation has been reduced under the current framework, the authorities remain concerned about persistently high bank lending rates. Inflation has also been higher than targeted, and highly volatile. 12. Tailoring the monetary policy framework to Zambias circumstances involves several considerations. Responding appropriately to exogenous shocks will require greater monetary policy flexibility, increased reliance on multiple indicators and forward-looking

The IMF has fielded several recent TA missions in the areas of tax policy, revenue administration, and public financial management. The pace of implementation has at times been affected by capacity limitations, political will, and, occasionally, differences of views.

8 structural analytical models, and a clear understanding of the transmission mechanism.6 An appropriate policy framework lies on a continuum from strict adherence to intermediate targets to the constrained flexibility associated with formal inflation targets. In the middle are regimes that incorporate elements from both ends, many of which can be described as ITlite (Stone, 2003). Structural characteristics influence this choice, and any shift in monetary arrangements should recognize that Zambia still has several structural characteristics that make some degree of money targeting desirable. These include (i) relatively larger fiscal and real economy shocks, including volatile terms of trade,7 (ii) a remaining risk of fiscal dominance, (iii) still-developing central bank capacity, and (iv) thin financial markets and a relatively weak role for interest rates in the transmission channel. 13. Several policy actions are needed to prepare Zambia for a shift toward more flexible monetary arrangements. High central bank credibility is important in any regime, but particularly critical in the transition to more flexible arrangements. To build and maintain high credibility, conflicting monetary Laying the groundwork for enhanced monetary flexibility policy goals (e.g., low lending rates Ensuring high central bank credibility Liquidity management, fiscal-monetary coordination, and and price stability) must be avoided data sharing and clarity provided in policy Improved interbank money markets to reduce interest rate objectives, operational frameworks, volatility and the holding of excess reserves and communication strategies. Financial sector development to strengthen the interest Zambias legacy of high inflation rate and credit channels of monetary transmission Increased capacity for modeling and inflation monitoring may still influence expectations and Enhanced central bank communications could also undermine credibility. In High frequency economic statistics monetary operations, Zambia needs to avoid central bank financing of the budget and unplanned reserve accumulations that are unsterilized, which have led to volatile and excessive money growth; the resulting high and volatile excess reserves have weakened control over the money supply (Saxegaard, 2006). Financial sector deepening (see below) would enhance the effectiveness of monetary policy, particularly through the credit and interest rate channels. Without complementary actions in areas such as these, moving to more flexible monetary policy arrangements could jeopardize the attainment of price stability objectives and sacrifice hard-won policy credibility. B. Infrastructure Development Presents Twin Challenges 14. Low income countries require greatly enhanced public infrastructure to achieve sustained faster economic growth with economic resilience (IMF and World Bank, 2011). By increasing the stock and quality of their infrastructure to that of Mauritius, for example, it
6 7

Baldini and others, 2011; Berg and others, 2010; Peiris and Saxegaard, 2007.

The advantages of money targeting versus interest targeting depend on the type of shocks faced (Poole, 1970; Berg and others, 2010).

9 is estimated that Sub-Saharan LICs could raise annual per capita income growth by 2 percentage points (Calderon, 2009). In Zambia, foreign-financed infrastructure spending has declined sharply, and domestic capital spending has consistently fallen short of plans (see chart in Section II)perhaps contributing to rather narrowly-focused growth (paragraph 8). Scaling up infrastructure presents two key challenges: investing efficiently, and financing that investment in a manner that does not undermine debt sustainability. 15. All countries face obstacles to efficient public investment, but in LICs these are a key constraint to growth. As one observer has noted: In these economies, development is fundamentally about raising the capacity to invest productively (Collier, 2010). Strong operational frameworks are needed to translate public investment spending into effective capital accumulation. For public infrastructure, this requires strategic guidance to inform sector-level decisions; independent review and analysis of project feasibility; and transparent, effective processes for project selection, budgeting, implementation, project evaluation, and audit (Rajaram and others, 2010). While Zambia scores above many other LICs, a recent index of public investment management (PIM) indicates that much scope exists to improve the PIM process (Dabla-Norris and others, 2011); for Zambia, project appraisal capacity has been a particular concern. The two recent Fund-supported programs have promoted broader public financial management (PFM) reforms, but implementation has lagged and weaknesses continue to inhibit spending efficiency. Episodes of misappropriation of donor funds at the Ministry of Health and a range of discrepancies at the Road Development Agency have also discouraged some donors from participating in projects; governance reforms are underway in those areas. 16. Sustainable financing is the second key challenge in infrastructure development. Although strong macroeconomic performance and debt relief have returned Zambias external debt to sustainable levels, Zambia, like other LICs, faces huge financing requirements and a need for large-scale grants and highly concessional loans. With only low debt vulnerabilities, however, Zambia can finance productive investments on market terms, within the limits of a sound debt management strategy. Further developing that strategy and supporting it with improved debt management is critical to infrastructure development.

10 C. Mobilizing Domestic Revenues 17. Many LICs face continued needs for social spending, the possibility of reduced aid, and large financing needs Elements of Tax Reform in Developing Countries for infrastructure and to Build effective revenue administrations address climate change (IMF Dedicate offices for large taxpayers and key sectors staff, 2010). Tax system reform to Pursue forceful, efficient strategies against non-compliance Levy VAT on a broad base, with a high threshold mobilize domestic revenues is Avoid exemptions that jeopardize revenue and governance, are critical to meeting these needs. Its hard to reverse, or lack clear social benefits design should consider tax Enhance transparency and analysis of tax expenditures fairness, how various taxes affect Employ a simple, broad-based corporate tax with effective tax efficiency and growth, and the rates that are low and uniform across investments diversification of revenue sources Extend coverage of personal income taxes to professionals and smaller businesses; tax capital income coherently in order to reduce revenue Balance natural resource (NR) royalties, auctions, and profitvolatility. Effective tax system related charges; manage NR revenues transparently reform can also support Improve capacity to deal with multinationals profit shifting institutional development and Develop real property taxation to finance local services support formal sector activity. Cross-country experience (IMF, 2011) identifies several key elements applicable to most LICs (see text box), although the specific priorities vary in each country. 18. Well-designed tax system reform backed by sustained political support pays off. Despite reduced trade taxes, over the past decade the median LIC tax revenue/GDP ratio has increased by 3 to 4 percentage points, with improvements in both resource-rich and nonresource countries. In some countries, tentative successes unraveled when political will softened, but experiences such as that of Tanzania, which raised its TR/GDP ratio by 6 points in nine years, demonstrate the benefit of sustained reforms. 19. Zambias revenue performance contrasts sharply with the experience of comparator countries. Like many LICs with natural resources, it has not enhanced nonmineral fiscal revenue collections; unlike Zambia: Revenues them, it has not, until perhaps very recently, (Percent of GDP) received consistently higher mineral revenues 2002-04 2005-07 2008 2009 2010 Est. (IMF, 2011). The reasons include narrow tax Tax 17.4 17.1 18.1 15.0 16.9 bases due to incentives, exclusions, and Income 7.8 7.9 9.0 7.9 9.4 exemptionsa lesson emphasized in the 2004 VAT 5.1 4.9 4.0 3.8 4.1 EPA. As a result, Zambias tax and revenue Excise 2.4 2.4 2.6 1.6 1.8 Customs 2.1 2.0 2.4 1.7 1.6 ratios stand at or slightly below their levels at Non tax 0.6 0.6 0.8 1.0 0.9 the start of the review period. In mining, generous terms for new investment, locked in Sources: Zambian authorities; and IMF staff estimates. by fiscal stability agreements, translated into relatively little revenue when copper prices rose sharply (Hogan and Goldsworthy, 2010). Attempts to scrap the terms of these agreements

11 brought litigation and uncertainty. Despite positive copper price developments, mining tax receipts reached only 2 percent of GDP by 2010, compared to 4 percent projected at the start of ECF-2. Recent reforms improved the system, and Zambias voluntary progress toward validation under the Extractive Industries Transparency Initiative (http://eiti.org) should increase public interest and confidence in minerals revenues, and thus help to build support for reforms. 20. Mobilizing domestic revenues should be a priority for the next several years. For Zambia, areas that deserve particular attention include a gradual withdrawal of widespread existing tax incentives and the introduction of a tax expenditure budget; more attention to consumption taxes; and substituting non-tax revenues with property taxesaccompanied by strengthened fiscal decentralization legislation. D. Financial Sector Development 21. Having improved financial sector stability, Zambia should now extend the focus of reforms to include financial sector development in order to enhance growth and resilience. Gradual liberalization of the banking sector has facilitated competition and entry of foreign banks, but the banking sector remains shallow and concentrated, with real lending rates among the highest in the region and low levels of financial access. The home-grown financial sector development plan (FSDP) encouraged under the ECFs fostered stability,8 but less progress has been made on financial development.
Zambia: Indicators of Financial Development, 1990-2010
Zambia LICs SSA-LICs SSA-MICs 1990-99 2005-10 1990-99 2005-10 1990-99 2005-10 1990-99 2005-10 Bank Deposits/GDP Private Sector Credit/GDP M2/GDP 14.7 6.9 17.7 18.5 11.0 21.6 21.6 16.0 27.7 49.7 33.4 38.4 16.0 10.6 22.7 62.8 33.3 30.6 33.1 25.2 35.5 42.9 35.6 49.1

Sources: IMF; World Economic Outlook; International Financial Statistics; and IMF staff estimates. Note: Simple averages.

See Financial Sector Stability Assessment (IMF, 2009).

12
Financial Access Strands f or the Various FinScope Survey Countries Zambia '09 South Africa '09 Botswana '08 Namibia '07 Rwanda '09 Nigeria '08 Malawi '08 Tanzania '09 Mozambique '09 12 12 1 14 21 19 4 10 Formal Other Informal 7 2 7 27 78 Financially excluded 41 45 26 24 19 22 14 9 14 60 18 8 52 52 53 55 56 63 4 10 33 6

Banked

Source: FINScope Zambia, 2009.

22. Cross-country experience suggests that a more developed financial sector could strengthen resilience and stability. Shallow financial markets limit monetary policy effectiveness, and financial development in Zambia can strengthen the interest rate and credit channels of monetary transmission and reduce the relative role of (often volatile) exchange rate movements (Laurens et al., 2005; IMF 2006, 2008). Reduced operating costs, including with regard to overhead, holdings of excess reserves, and collection of nonperforming loans, is also key to reducing lending rates. 23. Financial sector development fosters economic development through several channels.9 Most studies confirm that countries with better-functioning financial systems grow faster and experience more rapid poverty reduction (Levine 1997; Beck et al., 2000, 2004). Finance helps economies grow faster through improvements in resource allocation and productivity growth. The link between finance and growth operates by relaxing firms financing constraints and facilitating expansionespecially for small firms (Rajan and Zingales, 1998; Beck et al., 2005). These effects can be especially important in highlyconcentrated economies such as Zambias, which requires diversification to strengthen resilience and to support more broad-based growth. 24. Regional financial integration may be one strategy to overcome the high costs that now limit the scope and volume of financial services. Some steps toward harmonizing regulatory frameworks, for example, could effectively expand market size, exploit economies of scale, and foster competition that would reduce margins and promote the delivery of a broader range of services to wider segments of the economy. Doing this in a manner that

Although there is some debate about the causality between financial sector development and growth, there is increasing evidence in favor of financial sector development causing growth, reducing poverty and inequality.

13 promotes financial development while also ensuring stability is a complex undertaking; the IMF and Zambias development partners can provide policy advice and technical assistance. 25. Financial sector development can also be fostered through other channels. Phase II of the Financial Sector Development Plan (FSDP-II) identifies several reforms where the Fund has an active role to play, including in pursuing the goal of increasing competition and stability through a stronger regulatory framework, the orderly exit of failing institutions, and a sound crisis management framework. Other channels of development could include innovative technologies such as mobile banking, which is used in Kenya and elsewhere to enhance market access. Improvement in the operating environment, such as strengthened contractual frameworks and property rights, can also reduce costs, promote competition, and reduce spreads (Honohan and Beck, 2007). Similarly, development of nonbank financial institutions can encourage lending products suited to Zambias legal and institutional setting. In these areas as well, the Fund can support the authorities in promoting financial sector development to enhance economic resilience and growth, and can play a direct role in those areas most closely related to stability. IV. FUTURE FUND ENGAGEMENT 26. A well-articulated medium-term economic program would help Zambia to strengthen resilience and raise growth rates. The authorities should anchor their program on policies to promote continued macroeconomic stability, while emphasizing sustained medium-term reforms, particularly in the areas discussed above. The Fund could provide support for such a medium-term program, with the choice of instrument depending on economic circumstances. A successor arrangement could be prepared under the Extended Credit Facility (ECF), which could provide further concessional financing. If the qualification criteria for a PSI are met, including on institutional capacity, the Policy Support Instrument (PSI, a non-financial arrangement) could be appropriate. A PSI could be complemented by financial support under the Standby Credit Facility (SCF) in case of an actual or potential balance of payments need. A Fund-supported program would provide a strong framework for policy support and frequent assessments of Zambias economic and financial policies, which have an important signaling role for donors, creditors, and the general public.

14 References Baldini A., J. Benes, A. Berg, M. Dao, and R. Portillo, 2011, Monetary Policy in Low Income Countries in the Face of the Global Crisis: the Case of Zambia, IMF Working Paper, forthcoming. Beck, T., A. Fuchs, and M. Uy, 2009, Finance in Africa: Achievements and Challenges, World Bank Policy Research Working Paper No. 5020 (Washington: World Bank). Beck, T., R. Levine and N. Loayza, 2000, Finance and the Sources of Growth, Journal of Financial Economics. Beck, T., A. Demirguc-Kunt, and V. Maksimovic, 2005, Financial and Legal Constraints to Firm Growth: Does Firm Size Matter? Journal of Finance. Berg, A., R. Portillo, and F. Unsal, 2010, Optimal Adherence to Money Targets in LowIncome Countries, IMF Working Paper 10/134 (Washington: International Monetary Fund). Calderon, C., 2009, Infrastructure and Growth in Africa, World Bank Policy Research Working Paper No. 4914 (Washington: International Monetary Fund). Collier, P., 2010, Principles of Resource Taxation for Low-income Countries, in The Taxation of Petroleum and Minerals: Principles, Problems, and Practice, ed. by P. Daniel, M. Keen, and C. McPherson. Dabla-Norris, E., J. Brumby, A. Kyobe, Z. Mills, and C. Papageorgiou, 2011, Investing in Public Investment: An Index of Public Investment Efficiency, IMF Working Paper 11/37 (Washington: International Monetary Fund). Hogan, L. and B. Goldsworthy, 2010, International Mineral Taxation: Issues and Experience, in P. Daniel, M. Keen, and C. McPherson, 2010, The Taxation of Petroleum and Minerals: Principles, Problems, and Practice. Honohan, P and T. Beck, 2007, Making Finance Work for Africa (Washington: World Bank). IMF, 2011, Revenue Mobilization in Developing Countries (Washington: International Monetary Fund). IMF, 2010, Zambia--Fourth Review under the Three-Year Arrangement under the ECF, IMF Country Report No. 10/208 (Washington: International Monetary Fund). IMF, 2010, Reaching the MDGs: Macroeconomic Prospects and Challenges in LICs, Background Note by IMF Staff for the United Nations MDG Summit (Washington: International Monetary Fund).

15 IMF, 2009, Zambia-Financial Sector Stability Assessment (Washington: International Monetary Fund). IMF, 2008, Regional Economic Outlook, April: Sub-Saharan Africa, Monetary and Exchange Rate Policies in Sub-Saharan Africa, Chapter 2. IMF, 2006, Regional Economic Outlook, April: Sub-Saharan Africa (Washington: International Monetary Fund). IMF, 2004, Zambia-Ex Post Assessment of Performance under Fund-Supported Programs, IMF Country Report No. 04/214 (Washington: International Monetary Fund). IMF and World Bank, 2011, Global Monitoring Report 2011: Improving the Odds of Achieving the MDGs (Washington: World Bank). Laurens, B. and others, 2005, Monetary Policy Implementation at different Stages of Market Development, IMF Occasional Paper No. 244 (Washington: International Monetary Fund). Levine, R., 1997, Financial Development and Economic Growth: Views and Agenda, Journal of Economic Literature. Mikkelsen, 2008, ZambiaMonetary Policy and Inflation, IMF Country Report No. 08/29 (Washington: International Monetary Fund). Peiris S. and M. Saxegaard, 2007, An Estimated DSGE Model for Monetary Policy Analysis in Low-Income Countries, IMF Working Paper 07/282 (Washington: International Monetary Fund). Poole, W., 1970, Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model, Quarterly Journal of Economics. Rajan, R., and L. Zingales, 1998, Financial Dependence and Growth, American Economic Review. Rajaram, R., T. Le, N. Biletska, and J. Brumby, 2010, A Diagnostic Framework for Assessing Public Investment Management, World Bank Policy Research Working Paper No. 5397 (Washington: World Bank). Saxegaard, M., 2006, Excess Liquidity and Effectiveness of Monetary Policy: Evidence from Sub-Saharan Africa, IMF Working Paper 06/115 (Washington: International Monetary Fund). Stone, M., 2003, Inflation Targeting Lite, IMF Working Paper 03/12 (Washington: International Monetary Fund).

16

Appendix Table 1. Performance on Quantitative Performance Criteria and Benchmarks under the 2004-07 PRGF
Net domestic assets of Bank of Zambia Government net domestic financing Gross international reserves Nonaccumulation of government external payment arrears Short-term and nonconcessional debt ceiling New concessional borrowing ceiling Payment of government domestic arrears Central Government wage bill ceiling Central Government wage arrears ceiling HIPC account deposits floor Sept. PC PC PC PC PC PC PC Not met Ind Ind Ind 2004 Dec. PC PC PC PC Not met PC PC PC Ind Ind Ind Mar. PC PC PC PC PC PC PC Ind Ind June PC PC PC PC PC PC PC Ind Ind 2005 Sept. PC PC PC PC PC PC PC Ind Ind Dec. PC PC PC PC PC PC PC Ind Ind PC Ind Ind PC Ind Ind Ind Not met Ind Ind PC Ind Ind PC Ind Ind PC Ind Ind Mar. Ind June PC 2006 Sept. Ind Dec. PC Mar. PC PC PC PC PC 2007 June PC PC PC PC PC

Ind PC Ind PC Not met Not met Not met Not met Ind PC Ind PC Ind Ind PC PC Ind Ind PC PC

Source: IMF staff reports Note: PC indicates performance criteria and Ind indicative targets.

Appendix Table 2. Performance on Quantitative Performance Criteria and Indicative targets under the 2008-11 ECF
June PC PC PC PC PC PC 2008 Sept. Ind Ind Ind Ind Ind Ind Dec. June PC PC Not met PC PC PC Not met PC PC PC PC PC PC 2009 Sept. Ind Dec. PC Mar. Ind June PC PC PC PC PC PC Ind Not met Ind. Ind 2010 Sept. Ind Ind Ind Ind Ind Ind Ind Dec. PC PC Not met PC PC PC PC

Net domestic assets of Bank of Zambia Government net domestic financing Gross international reserves Nonaccumulation of government external payment arrears Short-term external debt ceiling Medium- and long-term nonconcessional external debt ceiling Payment of government domestic arrears Increase in reserve money Government social spending

Ind PC Ind Not met Not met Ind PC Ind Ind Not met Ind PC Ind Ind Ind PC Ind Ind Ind Ind Ind

PC Ind PC Not met Not met Not met Ind. Ind Ind Ind Ind Ind Not met Not met Not met Not met Ind Ind Ind Ind Ind Ind Not met Not met Not met

Ind Not met Ind Ind Not met Not met Ind Ind

Source: IMF staff reports Note: PC indicates performance criteria and Ind indicative targets.

17 Appendix Table 3. Zambia: Performance on Structural Performance Criteria and Structural Benchmarks Under the 200407 ECF
Measure Cabinet approval of the PEMFA program Submission to Cabinet, for consideration and approval, of an action plan for initial implementation of the Financial Sector Development Plan The government will refrain from paying any amounts for which it is not legally liable and which are not included in the budget Publication of quarterly budget execution reports using the activity-based budgeting classification, within 45 days of the end of each quarter Award a contract for the supply and installation of the hardware and software needed to implement the IFMIS Start negotiations for settlement of domestic arrears identified in the multiyear plan for clearing domestic arrears Type of conditional ity Initial Test Date Prior action Program approval Implementation Completed as planned Area Public Expenditure Management

Prior action Program approval

Completed as planned

Financial Sector Reform

PC

Continuous

Public Expenditure Management

SB

Continuous

Public Expenditure Management

SB

End-June 2004

Completed with delay (September 2004)

Public Expenditure Management

SB

End-July 2004

Completed as planned

Public Expenditure Management

Initiate the pilot implementation of the IFMIS in at least three line ministries Define a policy for the granting of tax concessions

PC SB

Reset to end-June 2005, then endEnd-September 2004 Sept.2006, pilot began in Jan. 2007 End-September 2004 No information on implementation

Public Expenditure Management Tax Policy

Cabinet approval of a proposal to repeal the sections of the Building Societies Act, the National Savings and Credit Bank Act, and the Development Bank of Zambia Amendment Act that are in conflict with the Banking and Financial Services Act PC

Transformed into prior action for the End-November 2004 second review

Financial Sector Reform

Adoption by the Government and the Bank of Zambia of action plans, finalized in consultation with the World Bank and IMF staff, for the resolution of the National Savings First Review Prior and Credit Bank and the Development Bank of Zambia Prior action action Unforseen expenditures will be funded only to the limits of the budget contingency or after Cabinet approval including the identification of savings elsewhere in the budget

Completed as planned

Financial Sector Reform

SB

Continuous

Governance and Transparency

Adopt a work program covering the first year of the implementation of the PEMFA reform program PC Adopt a definition of poverty reducing spending corresponding to the priorities of the government PRSP and use this in the preparation of the budget for 2005 SB Report on the findings of a preliminary review of the piloting of the IFMIS in at least three line ministries PC In consultation with the PEMFA Technical Working Group, design a cash-flow framework for all line ministries SB In consultation with the PEMFA Technical Working Group, finalize a framework for monitoring and evaluating the PEMFA program Prepare and publish the first draft ("Green Paper") of the MTEF for 2006-2008 Issue new regulations and revised accounting manuals for the new Finance Act Complete review of the implementation of the PEMFA program Beginning with the second quarter of 2005, validate end-quarter external debt stock data and, within 45 days, provide updated 3-year schedule of debt service falling due to the budget director The NSCB and the DBZ submit to the BoZ plans for their incorporation in 2006 under the Companies Act.

End-January 2005

Completed as planned

Public Expenditure Management

End-January 2005

Completed as planned Reset to end-March 2007 and then End-December 2005 postponed.

Public Expenditure Management Public Expenditure Management

End-May 2005

Completed with delay (August 2005)

Public Expenditure Management

SB SB SB SB

End-May 2005 End-August 2005

Completed with delay (July 2005) Completed with delay (November 2005)

Public Expenditure Management Public Expenditure Management Public Expenditure Management Public Expenditure Management

End-September 2005 Completed with delay (December 2006) End-November 2005 Completed as planned

PC

Continuous

Debt Management

SB

End-December 2005 Completed as planned

Financial Sector Reform

Adoption by the government and the Bank of Zambia of action plans finalized in consultation with the World Bank and IMF staff, for the resolution of the Zambia National Buiding Society (ZNBS) SB The Investment and Debt Management Department (IDM) of the MoFNP will validate the stock of onlending agreements with a view to effectively enforcing these agreements. The IDM will report to the Secretary of Treasury on the validation of these agreements PC The IDM will validate the stock of government contingent external liabilities, including loan guarantees, and pension obligations. The IDM will report to the Secretary of Treasury on the validation of these liabilities. Issue summary tables, developed in consultation with the PEMFA Joint Technical Working Group (JTWG), using activities based budgeting classification and identifying poverty reducing programs In consultation with the PEMFA JTWG, issue (i) accountability rules and procedures under the new cash management framework and (ii) corresponding administrative procedures for enforcement, to ensure the timely release of funds by the Ministry of Finance and National Planning Submit to Cabinet the first draft ("Green Paper") of the Medium-term Expenditure Framework (MTEF) for 2007-2009. Complete a diagnostic review of tax policy and administration

End-April 2005

Completed with delay (August 2005)

Financial Sector Reform

End-June 2006

Completed as planned

Debt Management

PC

End-December 2006 Completed as planned

Debt Management

SB

End-March 2006

Completed with delay (May 2006)

Public Expenditure Management

SB

End-March 2006

Completed with delay (May 2006)

Public Expenditure Management

SB PC

End-August 2006

Completed as planned

Public Expenditure Management Public Expenditure Management

End-December 2006 Completed as planned

18 Appendix Table 3. Zambia: Performance on Structural Performance Criteria and Structural Benchmarks Under the 200407 ECF (Continued)
The Accountant General will, within 60 days of the end of each quarter, submit to the Secretary of the Treasury quarterly reports on compliance with the commitment control system by ministry, province, and spending agency The MoFNP will issue an annual report on external debt management operations during 2005 Execute the action plan adopted by the Government on the resolution of the Zambia National Building Society

SB

Continuous

Public Expenditure Management

SB

End-June 2006

Completed as planned

Debt Management

SB

End-June 2006

Postponed to 2007. Impl unclear

Financial Sector Reform

Submit to cabinet a proposal for the legal framework establishing a credit reference bureau, including the necessary amendments to privacy laws SB Incorporate the National Savings and Credit Bank (NSCB) and the Development Bank of Zambia (DBZ) under the Companies Act ZESCO's management will provide all the necessary financial, technical, and managerial information to the World Bank and the IMF for an assessment of Zesco's performance in line with the conditions for reaching the evaluation point under the commercialization process The Central Statistics Office will complete a comprehensive economic census for the full rebasing of the national accounts Submit to the Minister of Finance a comprehensive debt management strategy

End-June 2006

Completed as planned

Financial Sector Reform

SB

Posponed until the finances of the End-December 2006 institutions are sounder. Impl unclear

Financial Sector Reform

SB

End-April 2006

Reset to end-July 2006, observed with delay No information on implementation available in staff report No information on implementation

Private Sector Development

SB PC

End-May 2007 End-June 2007

Statistics Debt Management

Source: IMF staff reports. Note: PC indicates performance criteria and SB indicates structural benchmarks.

19 Appendix Table 4. Zambia: Performance on Structural Performance Criteria and Structural Benchmarks Under the 200811 ECF
Measure Type of conditionality PC Initial Test Date Implementation Area

Submit to Cabinet a proposal to establish a treasury single account

End-June 2008

Completed as planned

Public Expenditure Management

Submit to Cabinet a policy for the electricity sector with specific startegies to (i) PC gradually adjust electricity tariffs to the cost of service; (ii) attract private investment and competition in the sector; (iii) increase the operational efficiency of ZESCO; has sufficient resources to implement the planned rehabilitation and new generation projectsand (iv) ensure that ZESCO Submit to Cabinet a proposal to establish a Treasury Department SB

End-June 2008

Completed as planned

Private sector legal and regulatory environment reform

End-June 2008

Completed as planned

Public Expenditure Management

Establish a headquarters functional structure at the Zambia Revenue Authority

SB

End-September 2008 Completed as planned

Public Expenditure Management

Establish a single large-taxpayer office at the Zambia Revenue Authority

SB

End-december 2008

Completed as planned

Public Expenditure Management

The Ministry of Finance and National Planning and the Bank of Zambia will establish a formal mechanism for coordination with key line ministries on liquidity management The Bank of Zambia will restructure the operations of its rediscount window Set up a supervisory regime for the secondary market in government securities Introduce risk based bank supervision Submit to cabinet a debt management strategy

SB

End-June 2008

Completed as planned

Public Expenditure Management

SB SB SB SB

End-June 2008

Completed with delay

Financial Sector Reform Financial Sector Reform Financial Sector Reform Debt Management Public Expenditure Management

End-December 2008 Completed with delay (March 2010) End-September 2008 Completed as planned End-September 2008 Completed as planned End-June 2009 Completed as planned

Prepare a comprehensive strategy for phased implementation of the establishment of the SB treasury single account system Approval by Cabinet of all necessary amendments to the Public Finance Management Act specifying the general principles of the treasury single account system Bank of Zambia will introduce a new standing overnight lending facility Raise the average electricity tariff in 2009 and publicly announce indicative tariffs for 2010-11 consistent with the policy to reach cost-reflective levels by 2011 Approval by Cabinet of the pay policy reform SB

End-September 2009 Completed as planned

Public Expenditure Management

SB SB

End-September 2009 Completed with delay (December 2009) Financial Sector Reform End-June 2009 Completed as planned Private sector legal and regulatory environment reform Public Expenditure Management

SB

End-June 2010

Completed as planned

Establish a Lender-of-Last Resort Framework and draft legislation and procedures for a financial sector contingency plan in the event of a crisis Adoption of Treasury Single Account by six ministries, provinces, and spending agencies Submit to parliament the Planning and Budgeting Act

SB

End-June 2010

Partially Met. Draft legislation expected Financial Sector Reform by end-May 2011 Public Expenditure Management

SB

End-December 2010 Not met. Expected to be met by endJune 2011 End-June 2010 Reset to end-December 2010 then endJanuary 2011. Delayed further

SB

Prepare a review of tax administration and policy

SB

End-September 2010 Completed as planned

Public Expenditure Management

Raise the average electricity tariff in 2010 and publicly announce indicative tariffs for 2011 consistent with the policy to reach cost-reflective levels by 2011 Submit to Cabinet a report on maize pricing policy

SB

End-June 2010

Completed with delay (July 2010)

Private sector legal and regulatory environment reform Private sector legal and regulatory environment reform Public Expenditure Management

SB

End-March 2011

Completed as planned

Adoption of Treasury Single Account so as to cover 60 percent of budgetary expenditures

SB

End-december 2010

Delayed

Source: IMF staff reports. Note: PC indicates performance criteria and SB indicates structural benchmarks.

20 Annex 1. Response of the Zambian Authorities The draft EPA Update was discussed with authorities of the Ministry of Finance and the Bank of Zambia in Lusaka on May 26-27. The authorities considered the EPA report timely and useful; they welcomed the presentation of Zambias key economic issues in a crosscountry context and broadly agreed with the conclusions of the report. The authorities emphasized the role of disciplined economic policies in Zambias strong economic performance since 2004, including strong disinflation, but also expressed concern that market interest rates remained high. Looking ahead, they saw their overarching objective as translating sustained rapid growth into faster rates of poverty reduction. The authorities agreed that the reports four forward-looking themes represented key economic issues for Zambia. They noted that steps were already underway in most of these areas, including an agenda for regional financial integration involving SADC. In addition, they emphasized the importance of reforms that would improve agricultural productivity and investment in the social sector to develop human capital. They highlighted that they also intend to focus on improving the quality of statistics produced in Zambia. The authorities felt that the very positive relationship with the Fund and Fund staff had contributed to Zambias improved economic policymaking. They highlighted the special role of the Funds Resident Representatives in providing on-the-ground advice and wise counsel. Regarding program design, they appreciated the flexibility of staff and the Fund in shifting the monitoring of non-concessional debt from a project-by-project basis (which the authorities characterized as micro-managing) to a sectoral basis.